Portfolio Theory: GICs vs. Bonds

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Yoder
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Portfolio Theory: GICs vs. Bonds

Post by Yoder »

So this is a re-hashing of the old GIC ladder vs. Bond fund question...

My simplistic understanding of "modern portfolio theory" is that the combination of two assets (A & B), with volatility (Va and Vb) and returns (Ra and Rb) can help you to create a new asset which has different characteristics: it has a return that is proportional to the proportion of the two assets, but as long as the assets are not perfectly correlated with each other - you can obtain a volatility which is less than their combination.

So... in this scenario, could a GIC ladder be considered its own asset class (i.e. with its own volatility, and return characteristics), and correspondingly its own correlation with the rest of your portfolio? And if so - could anyone more erudite than myself help me to understand what the differences would be between this asset class, vs. for instance a ladder of government bonds, or a bond fund such as CLF. (at least expressed in terms of RoR and volatility)
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NormR
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Re: Portfolio Theory: GICs vs. Bonds

Post by NormR »

Well, good luck on getting good vol data on the GICs. They have one but most people think they come without vol. Mind you, you'll see it if you try to sell.

Mind you, it's not at all clear that vol is that useful with bonds to begin with.
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Re: Portfolio Theory: GICs vs. Bonds

Post by Yoder »

I guess what I'm also wondering is if a GIC can be considered the "risk-free" asset referred to in modern portfolio theory, or if it should be considered a distinct asset class, I favour the latter.

Everyone complains right now of the low YTM of bonds/bond-funds etc..., and thus suggests considering a ladder of GICs as providing superior returns. To me it seems possibly that this line of thinking is a case of market timing however - no one quite knows when the NAVs of the bond funds will tank.
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Re: Portfolio Theory: GICs vs. Bonds

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I personally consider GICs and nominal (or conventional) government bonds to be in the same asset class. If the size of the GIC is limited, it is insured by the government and so has the same credit risk as a government bond. A GIC is less liquid -- there is no secondary market. Some GICs are "cashable" at an interest penalty, others are not. Government bonds do have a secondary market. As a result, I would expect the yield on a GIC to be slightly higher than for a bond, but not much.

Corporate bonds do have higher credit risk, and higher yield. But you can have shadings of risk within an asset category, and so I would still lump corporate bonds in with government bonds and GICs.

(Some commentators claim that the extra returns on corporate bonds are generally not worth the extra risk, with two exceptions: (1) BB rated bonds, which suffer from a dearth of demand because they are just below investment grade (2) AAAs and AAs that are very close to maturity and so short term, because investors placing short term money generally look elsewhere.)

As for Norm's point, volatility is usually not used as a risk measure for fixed income investments. Instead, investors usually look to (a) duration, i.e. how sensitive is a bond's price to changes in interest rates, (b) default risk, traditionally captured by a credit rating agency's rating, and (c) liquidity risk, i.e. how easy is it to get my money back before maturity, if I need to.

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Re: Portfolio Theory: GICs vs. Bonds

Post by Thorn »

A step back: you have some asset allocation in mind for cash, fixed income and equities. For me, the fixed income portion (GICs, bonds etc.) is an attempt to (1) preserve capital by ensuring the return exceeds inflation + taxes, and (2) deriving some income until maturity. I personally have no interest in trading my bonds even though the current prices are well above my purchase prices.

You can build a bond ladder of (say) 10 years with equal dollar amounts in each year and grade A or above bonds from a different Canadian corporation in each year. Over time this behaves as a GIC ladder might under better circumstances than at present - it provides an average return over the 10-year period.

At this time, I believe that government bond returns are unacceptable, which pushes the retail investor toward corporate bonds, preferred shares of stocks or common dividend stocks.

The bond ladder itself presents a problem unless you have a sizeable amount of capital, as the face value of each bond is $1,000. You will need to buy them at a premium from a bond dealer (typically a full-service brokerage like your bank's) at a premium (>$1,000). This provides you with a predictable income stream and a maturity with a capital loss. Some investors do this deliberately with a bond ladder, to generate losses that can offset equity gains in the future at tax time.

The alternative is a bond ETF, which is low-cost and liquid, but providing a dividend income stream and its related tax advantage. Please note that these funds contain bonds but are not fixed income - they are equities. They do not have a maturity, they do not deliver a constant income stream to maturity and they do not guarantee a par value at maturity.
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Re: Portfolio Theory: GICs vs. Bonds

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The alternative is a bond ETF, which is low-cost and liquid, but providing a dividend income stream and its related tax advantage. Please note that these funds contain bonds but are not fixed income - they are equities. They do not have a maturity, they do not deliver a constant income stream to maturity and they do not guarantee a par value at maturity.
But they are still bonds, not equity. At any point of time, the market value of a bond ladder and a bond ETF of similar composition (duration, maturity, rating, etc.) is in principle identical (the ETF may in fact be more liquid).
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Re: Portfolio Theory: GICs vs. Bonds

Post by Peculiar_Investor »

Thorn wrote:The alternative is a bond ETF, which is low-cost and liquid, but providing a dividend income stream and its related tax advantage. Please note that these funds contain bonds but are not fixed income - they are equities. They do not have a maturity, they do not deliver a constant income stream to maturity and they do not guarantee a par value at maturity.
I'd like to explore this idea further in the context of portfolio theory, as I previously used XBB and XCB for my fixed income allocation. I agree with your characterization that "They do not have a maturity, they do not deliver a constant income stream to maturity and they do not guarantee a par value at maturity" but I'm not sure I can agree with "but are not fixed income - they are equities".

For example if one is building a couch potato indexing portfolio and requires xx% in Fixed Income, an obvious choice is XBB as it tracks the broadest Canadian bond index. My view is that until such time as there is an income need from the portfolio, an investor should be steering towards XBB (or an equivalent bond ETF) for the fixed income portion of their asset allocation. You are capturing the broad bond index return. The only reason I can see switching to individual holdings via a bond and/or GIC ladder is when income needs become part of the requirement from the fixed income asset allocation, say 10 years out from expected retirement.

One further question/clarification. Your statement (my bold)
Thorn wrote:The alternative is a bond ETF, which is low-cost and liquid, but providing a dividend income stream and its related tax advantage.
does not agree with XBB Distributions - iShares ETFs which shows the Annual Distributions as mostly Other Income, plus some Gain Gains and Return of Capital. There has never been any portion classified as a Dividend. The same holds true for XCB Distributions - iShares ETFs.
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Re: Portfolio Theory: GICs vs. Bonds

Post by Shakespeare »

The alternative is a bond ETF, which is low-cost and liquid, but providing a dividend income stream and its related tax advantage.
I missed that. Unfortunately, that statement is wrong from two perspectives:

1. The income is fully taxable, not dividend income.
2. In a non-registered account there will be a tax disadvantage when premium bonds are in the held in the ETF. See Conventional Bonds - finiki

Much of the post prior to that point (and my earlier criticism) is correct.
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Re: Portfolio Theory: GICs vs. Bonds

Post by ghariton »

Bond ETFs are not the same as individual bonds, but they are a pretty close substitute. In particular, the same factors are at play. The biggest is market risk (also known as interest rate risk). If interest rates move, the prices of both bond ETFs and individual ETFs will move in the opposite direction. How sensitive they will be (how much the price changes in response to say a 1% change in interest rates) depends on the duration (and, to a lesser extent, the convexity, etc). Arguably, purchasing individual bonds lets you pick your duration, while with an ETF you have to accept whatever duration the ETF managers have decided on. But this is usually not a big deal.

Credit risk is the second biggest kind of risk. If you are looking at government bonds or government bond ETFs, then the credit risk is the same for the two options. If you are looking at corporate bonds, then an ETF will diversify some of that risk. Diversification is possible with individual bonds, of course, but you have to be investing a lot of money or be willing to incur higher costs.

The third big risk factor is liquidity risk. How easy is it to sell your holding if you need your money in a hurry? Here, ETFs are generally more liquid, and sometimes much more liquid. The market for bond ETFs is "thicker" than the market for individual bonds. But I would argue that the average individual investor needs liquidity for only a very small part of his holdings.

In addition to risk, you should think about relative costs. ETFs have low upfront costs -- perhaps a $10 commission for buying or selling if you have self-directed account with enough money in it. But they have annual charges of 0.1% to 0.3% of the amount you hold, and than can add up over time. For example $200,000 in a bond ETF with a 0.3% MER will cost you $600 per year and compounding. By contrast, the cost of bonds is in the dealer's bid-ask spread. A typical "haircut" is 0.5% to 1.5% when you buy and another 0.5% to 1.5% when you sell, or $1,000 to $3,000 plus another $1,000 to $3,000. Of course, if you hold to maturity, you only pay the first $1,000 to $3,000. But there is no annual fee. So individual bonds cost less if you plan on holding for five years or more.

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BRIAN5000
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Re: Portfolio Theory: GICs vs. Bonds

Post by BRIAN5000 »

while with an ETF you have to accept whatever duration the ETF managers have decided on.
What about BulletShares you can choose the Duration you want and end maturity date with Corporate or High Yield.

http://www.guggenheimfunds.com/librarie ... e_etfs.pdf

http://www.guggenheimfunds.com/etf/fund/bscd
This information is believed to be from reliable sources but may include rumor and speculation. Accuracy is not guaranteed
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Re: Portfolio Theory: GICs vs. Bonds

Post by Thorn »

Great comments, folks! Thanks for straightening me out about some ETF payouts - they sound a lot like income trust payours, which I find a little annoying, since each return of capital means I need to re-calculate my adjusted cost base.

A few more observations:
(1) The Canadian bond market trading volume is about $25-26B daily, as opposed to $5-6B for the TSX equity market, and of course the daily money market is much larger (8x?) than the bond market.
(2) The bond market is not transparent - the agent will quote a price which you may take or refuse. In many cases the agent will not disclose the markups related to the operations of their wholesale, retail and agency bond desks. However, the market is quite competitive (you can get quotes from more than one agent), so markups are quite low.
(3) Canadian bond prices are re-calculated on a daily basis to reflect current interest rates and the coupons on comparable Government of Canada issues. Because I hold them for income, I ignore any pricing changes between purchase and maturity, because the $1K face value will be returned to me at maturity.
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